Corporate Finance Manual

Understanding corporate finance: derivative contracts: what is a derivative?

Definition of a derivative

A dictionary definition of a derivative is

‘a financial instrument whose performance is based on (or derived from) the movement of the price of an underlying asset, which does not have to be bought or sold.’

This is not a statutory definition. CTA09/S576 sets out what a ‘derivative contract’ is for corporation tax purposes.

Terminology

The word ‘derivative’ has only been in common use since the 1980s, although the idea is not new. Terminology is not standard throughout the derivatives industry. Derivative products, and the terms used to describe them, are constantly evolving. If HMRC staff come across a term that is unfamiliar, they should ask the company to explain it. They should not jump to conclusions about the tax treatment of a derivative contract merely on the basis of how the contract is referred to in the company’s accounts or computations, or in correspondence. They will need to look at the rights and obligations of each party under the contract and ensure they understand what each party pays and receives.

Underlying assets

The underlying subject matter of a derivative contract (often just referred to as the ‘underlying’) can be any asset or bundle of assets, tangible or intangible, real or notional, provided that one can attach a value or a measurement to it.

It may be something which is - at least in principle - capable of being delivered, such as foreign currency or a commodity. But equally:

The underlying asset may be something which does not actually exist, but which can be valued - for example, you can have derivatives based on notional loan relationships. Futures over government bonds typically track the value of a notional bond, with standardised features, regardless of whether or not an identical bond is actually in issue at the time. If holders of the future want to actually take delivery of a bond, they will receive real bonds of an equivalent value.

It can be something which is not deliverable, but can be measured, such as weather.

The derivative may be based on an index which tracks the price or behaviour of a whole collection of assets.